When You Buy These Miners, You Get What You Pay For

As long as you're gambling, everything is on the house: attention, entertainment, food, drinks. Ideally, winners never walk out the door. Casinos know that when given enough occurrences they always win and the gamblers always lose.

100% of nothing
Traditional mining stocks tend to have an all-or-nothing mentality, betting everything on one geographic location or project. Payoffs are spectacular! And failures are crushing. Franco-Nevada doesn't exactly own the casino, but its royalty structure looks nothing like a gamble. Franco-Nevada's strategy is to buy little interests in lots of mines. Breaking their assets down by stages, it has 38 "producing" assets, 22 "advanced," and over 100 "exploration." By spreading bets across the board, royalty mining stocks like Franco-Nevada better the odds of having 3% of lots of things as opposed to 100% of nothing.

Overcoming the 1-in-1,000 odds
Mining is the textbook example of a capital-intensive business. Profit potential can be large upon reaching the production phase, but until then (typically 5-10 years) losses occur nine times out of ten. Mining is a hard business, and that's if mining ever happens at all. Less than 1 in 1,000 discoveries will become a producing mine operation. Royal Gold is another option for investors who want exposure to metals and mining, minus the all-or-nothing type risk of gambling. Casting a broad net across companies and geographies, Royal Gold has 32 "producing" assets, 19 "development," and over 40 resources in the "exploration" phase.

Hedging against development risk
Pascua-Lama is located on the Chilean-Argentine border. Barrick Gold began building the mine in 2009; construction costs were estimated to be $3 billion. Water usage concerns, permitting issues, and construction challenges have contributed to costs overrunning by $5.5 billion (180%). Estimates for first production have been delayed beyond mid-2016, more than two years behind schedule.

Resulting from the delay, Silver Wheaton amended its $625 million purchase agreement (September 2009) with Barrick. The change entitles Silver Wheaton to 100% of the silver production from Barrick's Lagunas Norte, Pierina, and Veladero mines until the end of 2016 -- an extension of one year. While presenting at the Scotia mining conference last week, Silver Wheaton said the deal (Pascua-Lama) would be worth roughly $300 million under a worst case scenario.

What's the worst that can happen?
Over history, governments have occasionally revoked mining permits and confiscated property. That would be the worst case scenario: leaving companies with a lengthy court battle (international arbitration) to try to recoup sunk capital. Peru has a long history of mining, so it would be a surprise for this scenario to play out at Pascua-Lama. What happens if the mine operator (Barrick) goes bankrupt or sells mineral rights to someone else? In these scenarios, royalties and mineral interests typically carry forward / transfer to the new owner operator.

Premium financial product
In exchange for an upfront payment, mineral interests provide the owner with a long-term option on vast swaths of land, unseen values, and commodity prices. Geologically speaking, large resources (prospective land) with economic potential find their way into the hands of strong financial players. From there, cash flows are only a matter of time.

Some royalty stocks will even pay dividends while you wait. Franco-Nevada, Royal Gold, and Silver Wheaton are structured to provide exposure to metals prices while limiting the financing, development, and political risks associated with mining. Mr. Market values royalty stocks at a premium to traditional miners, however. Like most other things in life, you get what you pay for.

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The article When You Buy These Miners, You Get What You Pay For originally appeared on Fool.com.

Daniel Cook has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. mini-Mutual Funds are offered through Daniel T. Cook & Partners, LLC, registered with the State of Florida as a (RIA) Registered Investment Advisor. Office hours M-F 8am to 8pm. Telephone: (561) 596-5067. Custodial and clearing services are provided through Scottrade Advisor Services, member. SIPC

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